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The second quarter of 2021 saw continued appreciation of stock prices buoyed by rising commodity prices, especially copper and crude oil. The Vulcan Intrinsic Value portfolio gained by 6.0% for the quarter that ended June 30 and has appreciated by 22.1% for the year. We do anticipate a slowdown in stock market appreciation from here on, and are now adopting a cautiously optimistic stance vis a vis the portfolio.

Portfolio Changes

We added new positions during the quarter (see Table 1) in Absolute Software, Tata Motors, Cargo Jet, Cineplex, Coherus Biotech, Colfax and the iShares Biotech ETF. We sold our entire holding in Bird Constructions, First Quantum Minerals and Nielsen Inc. We also made partial changes to the portfolio, reducing our energy holdings (ARC Resources and Ovintiv) as well as reducing our investments in consumer discretionary and services (Gap Inc and Interpublic) while adding to our medical devices (Butterfly) and genetic testing technology company (Fulgent Genetics). Almost 30.0% of our new investments are in biotechnology and emerging medical tech.

Table 1: Additions and Deletions (changes as a percentage of the portfolio)

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Table 2: Partial Increases and Decreases (changes as a percentage of the portfolio)

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Forward View

We are in the early stages of an inflationary environment in Canada and the US. The latest data for June 2021 in Canada showed consumer prices, driven by food, fuel, housing and durable goods jumped by 3.6% over prices in June 2020. In comparison, in June 2020 consumer prices increased just 0.7% over June 2019. The increases in consumer prices this year are the highest in 10-years. The US was slightly worse with inflation rising 3.9% year over year for the month of June.

Stocks tend to do very well in these early stages of inflation build up, but peak quickly once interest rate hikes are implemented to temper inflationary pressures. The timing of this process is uncertain, however, and the pathway to interest rate hikes are rarely linear and this time is no different.

The difficulty of making investment decisions based on macro economic data and outlook was highlighted a short while ago. We participated in a sentiment/risk survey conducted by JP Morgan in June when the US 10-year treasury rate had risen rapidly to 1.56%. Three quarters of the portfolio managers surveyed (including us) thought that the US 10-year bond rate would be around 1.75-2.25% by year-end. The US 10-year rate plunged lower almost soon after the survey instead of going up and is currently at 1.25%.

Important market indicators besides interest rates are prompting us to be cautious. Firstly, the valuation of the companies comprising the S&P 500 index at over 22 times estimated earnings for 2022, is high, even after discounting for a upward earnings revision for most companies. Second, the volatility index (VIX) trading below 20 is at a multi-year low, which is normally a very bullish indicator but is also unsustainable at these levels. Thirdly, implied junk bond default rates (interest rates on bonds of companies rated below investment grade) are also at a multi year low;, in the past this has coincided with subsequent market panics.

Strategy

Q2 corporate earnings reporting season (underway at the time of writing) will clearly be strong, and early indications from earnings releases seen in the US, Canada and Europe are for blockbuster earnings growth. In the US 86.0% of companies reporting so far beat analyst estimates and most are raising full year guidance. However we would caution that comparisons from here on will start to get tougher.

While the rest of the year may undoubtedly be good, we have to look beyond 2021. The need to balance the continuing market opportunity which is driven by a surge in liquidity, with safety of capital is paramount. Risk/reward is not in favour of being overweight equities now. While our preference now is for low volatility assets, we are gradually also positioning the portfolio with a combination of cash, low volatility, very low duration income producing assets and equities. We are reducing market risk (beta factor) in the portfolio by re positioning the securities we own.

My preference at this point is for companies that are dominant in their industries, have, managements that have a solid track record and, strong brands, as well as relatively defensive sectors with competitive advantages. The portfolio will pivot to that over the next few months as we continue to redeploy sale proceeds away from high beta (higher market risk) names into lower beta and lower volatility names.

We will continue to add to healthcare, which is already our biggest area of investment. We own most of the major pharmaceutical companies as well as companies in promising areas of therapies and medical devices.

Energy: our view turns from core to tactical

We have been slowly winding down our very profitable energy positions with the intent to have a zero long term exposure to petro carbons. We intend achieving this in the near term. Having said that, we believe that energy prices will remain elevated and very volatile and will offer short term trading opportunities, which we will seek to exploit if to our advantage. For the second quarter we reduced half our holding in ARC Resources and one third of the holding in Ovintiv (see Table 2).

Overall, we are moderating our investment stance from growth and 75.0% equities exposure to moderate growth and 55-60% equity exposure. There is a risk that we may be a little early to exit the party but I believe this is the right course of action, at this point in time.

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